Why China Can't Outgrow Its Debt Burden

The National Audit Office (NAO), China’s state auditor, released the results of the government debt (re)audit on Dec 30, 2013. The audit covered debt obligations within five layers of government, including central, provincial, municipal, county and village/town, broader than the previous audit conducted in 2011.

The total debt is now estimated to have been RMB27.8 trillion by the end of 2012 and RMB30.3 trillion by mid-2013, about 53% of GDP. LocalLocal government debt is estimated to have been RMB17.9 trillion by mid-2013, lower than the market expectation.

The accuracy of the reported numbers is of course questionable, but we see that as less relevant than the government’s intended message to the market: Overall debt is still manageable, and local governments are burdened with more than 60% of the total debt.

Mainland policy makers and analysts commonly argue that the debt burden in itself is not a problem as long as GDP growth outpaces credit growth, and that credit-driven growth generates a positive return on investments. I believe that this argument is largely flawed, for the following reasons:

First of all, the debt issuers are not the primary beneficiaries of GDP growth. The primary beneficiary of GDP growth is the central government (which gains in the form of tax revenues), while debt issuers are mostly local governments (whose primary revenue source comes from land sales). There is no direct, mechanical, or automatic link between economic growth and local authorities’ debt service capacities, as we have witnessed since 2008 when total social financing, a broad measure of credit, exploded.

The argument that China can grow out of the credit bubble is valid if and only if GDP growth increases the debt service capacity of the debtors. As GDP is only a measure of economic activity, not efficiency or profitability, GDP growth alone does not guarantee a proportional increase in local authorities’ revenue that could be used to pay down debt issued via local government financing vehicles (LGFV).

However, local authorities could stand to benefit from GDP growth indirectly, if land value increases as a result of GDP growth. But again, the link between the growth in the size of the economy and the debt service capacity of LGFVs is by no means direct.

Can Hard Assets Be Drawn On to Repay Debt?

In mid-2013, investments in city construction, land reserves, transportation facilities and social housing made up 35%, 11%, 24% and 7% of the total spending by local authorities, respectively, according to CitigroupCitigroup analysts. Bulls would argue that these hard assets could be drawn on to repay the debt.

But the financial returns from the physical assets funded by LGFVs are largely unknown and mostly likely negative, judging by common sense. If those projects were financially viable, why didn’t local authorities invest in them prior to 2008 rather than waiting till the onset of the global financial crisis?

Studies show that few passenger railways in the world, including the longest running ones in Japan and Germany, are profitable if engines and carriages as well as the tracks are included in the capital cost. In the UK, for example, a separate company owns the track than those running the trains, and the revenues of the consolidated track and train companies do not cover the full cost. In Spain, revenues from actual and proposed high-speed railways cover less than half of operating cost, let alone capital costs, according to research by Pedro Casares and Pablo Coto-Millán.

It is clear that policy makers in China are focused on engineering a transition to slower but more sustainable growth without causing a sharp cyclical slowdown. From an empirical perspective, however, the number of economies that have historically succeeded in letting the air out of the credit balloon in a gradual fashion, without creating a credit crunch and a short-lived recession, cannot be counted on any fingers or any hands.

Whether China will be different, given its unique policy tools and central planning instruments such as quantitative credit controls, is yet to be seen. Nevertheless, policy intervention comes with costs, mostly higher and more convoluted than anticipated. One thing is certain: The consequences will be profound and long lasting to global economies and investors.

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